How pros ex­plains the stock mar­ket panic

The Pak Banker - - OPINION - Cass R. Sun­stein

CAN pro­fes­sional golf help ex­plain what is now hap­pen­ing with the­stock mar­ket? I think that it can, be­cause it of­fers a clue about an im­por­tant source of this month's mar­ket volatil­ity: hu­man psy­chol­ogy.

The best golfers make par on most holes. They also have plenty of chances to make a wel­come birdie (one un­der par) or to avoid a dreaded bo­gey (one over par). To do ei­ther, they have to sink a putt.

A stroke is a stroke, so you might think that whether a pro makes a putt can't pos­si­bly de­pend on whether the re­sult would be mak­ing a birdie or avoid­ing a bo­gey. But you'd be wrong.

A study of over 1.6 mil­lion putts shows that pro­fes­sional golfers are sig­nif­i­cantly more likely to suc­ceed in sink­ing a par putt than a birdie putt of equal dis­tance and dif­fi­culty. Re­mark­able but true: If the av­er­age top golfer putted as well for birdie as he puts for par, he would make an ad­di­tional $1.2 mil­lion a year.

Why do golfers do so much bet­ter when they are putting for par? The best ex­pla­na­tion, com­ing from be­hav­ioral sci­ence, is that most peo­ple are "loss averse," mean­ing that they dis­like losses a lot more than they like equiv­a­lent gains.

A loss from the sta­tus quo is very painful, and so peo­ple will do a lot to avoid it. A gain is good, but it isn't nearly as good as a loss is bad. Like the rest of us, pro­fes- sional golfers are af­fected by what John May­nard Keynes called "an­i­mal spir­its": the feel­ings of the prim­i­tive crea­tures who lie within us. Hat­ing the prospect of losses, golfers fo­cus in­tensely on avoid­ing those bo­geys, and of­ten suc­ceed.

Which brings us to the stock mar­ket. Of course it's true that the re­cent volatil­ity, and the sharp de­clines, have a lot to do with re­al­world events, in­clud­ing slower growth in China and rapidly fall­ing oil prices. But the fun­da­men­tals re­main pretty solid, and the ul­ti­mate ef­fects of such fac­tors are at least partly a prod­uct of psy­chol­ogy.

In­vestors know that stocks go up and down, but losses loom much larger than gains, and when the mar­ket gets es­pe­cially volatile it's tempt­ing to sell. Even if your port­fo­lio ends up the same on March 15 as it was on Fe­bru­ary 15, the in­terim losses tempt many peo­ple to get out. And if it's a ter­ri­ble month, a lot of peo­ple will want to avoid more bo­geys -- and scale back their hold­ings.

A closely re­lated phe­nom­e­non is called "prob­a­bil­ity ne­glect." When an out­come stirs strong emo­tions, peo­ple tend to ne­glect the like­li­hood that it will oc­cur. If the prospect of a bad re­sult gets the heart rac­ing -- a plane crash, a ter­ri­ble dis­ease, a loss of 30 per­cent of your port­fo­lio -- most peo­ple will take strong steps to avoid it. They will pay too lit­tle at­ten­tion to a com­fort­ing thought, which is that worst-case sce­nar­ios usu­ally don't come to fruition.

Loss aver­sion and prob­a­bil­ity ne­glect op­er­ate at the in­di­vid­ual level, but much of our be­hav­ior is a prod­uct of so­cial in­ter­ac­tions, which mul­ti­ply their ef­fects. Even when the fun­da­men­tals are strong, mak­ing sig­nif­i­cant mar­ket de­clines un­likely, in­vestors are af­fected by the ac­tions of other in­vestors. Like a bank run, a de­cline in stock prices creates its own mo­men­tum.

In the most ex­treme cases, what hap­pens, and what we are now wit­ness­ing, is an "in­for­ma­tional cas­cade," in which in­vestors at­tend to the sig­nals given by the be­hav­ior of other in­vestors, even if their own in­for­ma­tion sug­gests that the other in­vestors are wrong.

In­for­ma­tional cas­cades help fuel sell­offs. If many in­vestors are per­ceived to be sell­ing, there is a snow­ball ef­fect, as the "should sell" sig­nal gets louder, not be­cause peo­ple have re­li­able in­for­ma­tion that sell­ing re­ally makes sense but sim­ply be­cause of the be­hav­ior of oth­ers.

The good news is that in or­di­nary cir­cum­stances, in­vestor cas­cades are halted. The smart money is aware of ev­ery­thing I have said here, and if the fun­da­men­tals re­ally are strong, savvy in­vestors start buy­ing. They aren't loss averse, they don't ne­glect prob­a­bil­ity, and they spot op­por­tu­ni­ties when they see them. If there are enough of them, they can stop and even­tu­ally re­verse dra­matic move­ments driven by an­i­mal spir­its. His­tory tells us that in the long-run, equity mar­kets will do just fine. In the short-run, how­ever, the prospect of bo­geys can cre­ate a lot of havoc, es­pe­cially if a lot of peo­ple de­cide that they want to get out of the game.

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